Operational risk has come into greater focus in the last four to five years among OTC derivatives market participants, particularly in the wake of the financial crisis, according to a new report, Operational Risk Management in OTC Derivatives in Asia, from Celent.


OTC derivatives market volumes have recovered in the last year or so. The main worry with regard to the high volumes is the fact that a lot of these volumes are expected to shift to central clearing in the next few years. Moves are under way to ensure this in the leading Asian markets including Japan, Hong Kong, Singapore, Korea, China, Taiwan, and India.
Although operational risk has always been an important issue to address, it is becoming even more crucial because the rapid changes in regulation and implementation of processes associated with central clearing could put the medium-sized and small firms dealing with OTC derivatives in Asia in a precarious position, where (even if they are aware of the operational risks they are running) they might not have the technical capability or the resources to deal with the issues at hand.
In most of the cases, there has been a marked improvement in the capabilities of firms to automate processes and ensure that the number of errors are reduced, factors which reduce operational risk. However, there is a significant level of automation that remains to be undertaken, and it would become difficult (especially for the smaller firms) to free up the resources to undertake this.
A firm’s strategy, management, people, processes, and business conditions all play a role in influencing the levels of risk that the firm faces. On its part, the firm has to ensure that there are adequate checks and balances at all levels in its hierarchy, and transparency and accountability is emphasised upon. Collateral management, derivatives valuation, and calculation of the cash flows are important financial aspects that deserve attention. In this context, it is important to stress that increasing capital requirements are going to play an important role in the way a firm ameliorates operational risk. Hence, the costs of risk mitigation are expected to go up, and this is another important issue the smaller firms have to be cautious about while deciding the volumes of OTC derivatives they want to trade in the future.
Among the broad regulatory guidelines that are in place for market participants, the Basel II and III norms are useful in understanding the calculation of capital required to mitigate operational risk. Similarly, the framework suggested by the Committee of European Banking Supervisors (CEBS) is very helpful not just for the banks that trade in OTC derivatives, but also for the buy side and indeed non-financial players because it addresses the day-to-day practical issues that arise from such trading and how to deal with them from the point of view of operational risk.
